Economics 434: The Theory of Financial Markets Professor Burton Fall 2016 August, 25, 2016

Update on Class Information Office Hours: 11am-12pm Tues/Thurs at 1900 Arlington Blvd; Suite C Monroe Office: Room 262, 434-924-4054 VNB Office: 1900 Arlington Blvd., Suite C, 212-731-2340 Email: etb6d@virginia.edu Student lunches almost every weekday Class Website: https://pages.shanti.virginia.edu/ETB_Website/students-alums/class-pages/econ-4340-fall-2016/ New Readings for This Week: Chapters 1 – 3 in Textbook Section of Resources Tab in Collab August, 25, 2016

Fundamental Concepts Asset: something of value that represents real or potential monetary value in the future Default Free: a security that pays exactly what it promises to pay Risk Free: a security is risk free if the return is the same under all circumstances. The Risk Free Asset: this is the risk free security with the highest return The Risk Free Rate: the rate of return of the risk free asset August, 25, 2016

Arbitrage Buying and selling identical things simultaneously at different prices. An arbitrage profit means the selling price is higher than the buying price. If the timing of the buy and sell are not the same, then arbitrage is a return higher than that of the risk free asset, even though the transaction is risk free. August, 25, 2016

The No-Arbitrage Assumption Most finance theory does not rely on equilibrium models (though traditional CAPM is an equilibrium model) Instead, the usual assumption is that asset prices are such that no arbitrage opportunities exist August, 25, 2016

Imagine a security that pays in each period: So, what is risk? Uncertainty? Imagine a security that pays in each period: $ 100 if a coin flip is heads Minus $ 100 if a coin flip is tails What do you expect to make, in each period, if you own this security? On average? August, 25, 2016

August, 25, 2016